The art of spotting a winner

published 12 September 2007

Newcomers to buying shares need to start with the basics: find a good company that offers value for money. Here's how to do it.

How do I pick stocks that will beat the market?

Even if you had time to research companies all day and crunch numbers all night, there is no foolproof formula' that will tell you what shares to buy. If there were such a formula, everyone would already be following it and it would no longer help you beat the market. This is one reason that the past performance of companies and share prices is not (necessarily) a predictor of the future. Also, there are just too many variables to take into account, both quantitative (profits, cash flow, rate of growth, and so on) and qualitative (the people involved, the firm's reputation, the strength of its business sector, investor sentiment, etc). In short, stockpicking partly comes down to intuition and there's no guarantee you'll make money.

Then why bother buying individual shares?

Because it's potentially far more profitable than buying into a unit trust or other pooled investment fund as well as much more interesting. A FTSE 100 index-tracking fund might be cheap, but it is not going to be much use to you if the overall market is falling. If you pick for yourself a reasonably broad portfolio of (say) 15 to 25 companies, rather than buy into a diversified mutual fund of (say) 60 to 100, you have the potential to make much bigger gains assuming you (mostly) pick the right shares. Also, you have more freedom to back your educated guesses and put more of your money into the companies you really like. People who invested $10,000 in Bill Gates's software firm when it floated in 1986 would now have a holding worth in excess of $3m. You might not spot the next Microsoft, but learning how to pick shares will give you a better chance of becoming rich in the long run.

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Where do I start?

Much ink has been spilt on investing strategies for stock selection, with most writers generally in one of three camps. Value investors' look for companies trading below their true worth. Growth investors' look for companies that they think will get bigger in the future with a positive effect on the share price. And GARP' investors look for growth at a reasonable price'. In truth, while much is made of the divisions between these rival schools, they all boil down to the same thing value for money. Assuming you are buying shares for long-term capital growth (as opposed to current income or a speculative quick gain), you need to answer two questions. Is this a good, high-quality company with strong prospects? And are its shares currently cheap? There are plenty of good companies out there, but if their shares are currently fully valued by the market that is, if lots of other people already think that the company is so great that they want to own a piece of it then it's not going to make you any money.

So what's a good' company?

A company that can earn a higher-than-average return on capital (ie, how much profit the business makes divided by the capital it uses). You don't need a PhD in finance to spot a good company, but it helps to understand how it makes its money. One of the biggest lessons of the dotcom mania of the late 1990s is that not understanding a business model can have dire consequences. Many investors had no idea how dotcom and related companies were making a profit and indeed, most of these firms never did. But unless you understand how a company is generating revenue, you can't evaluate whether management is making the right decisions and whether you want to part-own it. What is its market share? Is it growing? What are the barriers to entry for competing businesses? How strong are its brands? What are its competitive advantages and what is its strategy for future growth? Is this sector or industry expanding or under threat? Who is running the company and what did they achieve at the last company they ran? If you can answer all these questions to your satisfaction, you may well have a suitable candidate for your investment if it's at the right price.

How do I know if the price is right?

A company is cheap if its current market price is less than its true intrinsic value which is the sum of its discounted cash flows, or (in plain English) all of its future profits added together. There's no way of knowing for certain what that figure is, so investors interested in long-term capital growth need to make an educated guess by analysing a firm's finances. A cheap company is one with a high earnings yield ie, that makes a decent profit compared to its price. The most widely used yardstick here is the price/earnings ratio' which compares the share price to the profits. Value investors look for stocks with low p/e ratios, which also meet other financial criteria.

When is a stock good value?

As well as a low p/e ratio, another key metric is the price/earnings to growth ratio (PEG), a stock's p/e divided by its projected annual growth rate. This ratio reflects how cheap the stock is while taking into account its growth rate. If a PEG is less than one (ie, the percentage growth rate is higher than the p/e ratio), value investors should be interested. The grandfather of this style of common sense investing is Benjamin Graham, whose pupil, Warren Buffett, is the most successful investor of all time. For more details, see www.investopedia.com. Or, for a clear and concise new spin on Graham's thinking by a successful professional investor, see Joel Greenblatt's The Little Book That Beats The Market.